Delaware Business Litigation Report

Superior Court Refuses to Permit "Pick Off" Of Class Representative

Stratton v. American Independent Insurance Company, C.A. 082-12-12 JRS CCLD ( May 11, 2011)

In this unusual fact pattern, a defendant paid the class representative the most the representative might have received for himself if the class claim were won and then argued the class action was moot.  The Court disagreed and did a careful analysis of why the class action could proceed despite the defense effort to "pick off" the class representative.

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The Viability of the Disclosure Only Settlement

This article was originally published in the Delaware Business Court Insider | May 11, 2011
 
For corporations facing stockholder litigation challenging a proposed business combination, negotiating a settlement in which the corporation agrees to provide additional disclosures without any increased consideration can be an efficient means of avoiding the risk of litigation.  The benefit created by the additional disclosures means the plaintiff’s lawyer can apply for a fee while the corporation and its directors get a release of all claims.

Some recent decisions of the Court of Chancery, however, have cast some doubt on the ability of a "disclosure only" settlement to serve as the sole consideration for a settlement or a substantial fee.  Practitioners on both sides should be aware of these developments when negotiating a settlement of litigation challenging transactions.

Although the Court of Chancery has not recently issued a written opinion refusing to approve a "disclosure only" settlement, there is precedent for doing so — e.g., the Delaware Court of Chancery's 2006 opinion in In re SS & C Technologies Inc.  The issue most recently came to light in Scully v. Nighthawk Radiology Holdings Inc., a much discussed case in which the court appointed special counsel to report on whether the settlement in that case was collusive and improper.

There, the plaintiffs sought expedited proceedings to enjoin a merger between Nighthawk Radiology Holdings Inc. and another party based solely on claims of inadequate disclosures.  The court denied the motion, in part, because the court felt the disclosure claims were not meritorious and, indeed, would not support a "disclosure only" settlement.  The corporation then reached a "disclosure only" settlement with the plaintiffs in a parallel proceeding in Arizona and agreed to present the settlement for approval to that court.  The Court of Chancery viewed this as an attempt to avoid its earlier admonition that a disclosure only settlement would not be adequate consideration to support a release for defendants, and appointed special counsel to investigate the matter.

While the special counsel in Nighthawk ultimately concluded that no collusion was present, the healthy skepticism of "disclosure only" settlements expressed by the Court of Chancery should be noted. Courts appear to be scrutinizing closely "disclosure only" settlements as part of a Delaware court’s independent duty to ensure that a settlement is fair and reasonable — e.g., the Chancery Court's 2005 opinion In re Cox Communications Inc. Shareholders Litigation.  That skepticism is most clearly manifested in recent decisions analyzing fee requests in which disclosures were part of the benefit created.

For instance, on April 30's In re Sauer-Danfoss Inc. Shareholder Litigation, Consol, the Court of Chancery considered a request for $750,000 by plaintiffs’ attorneys who claimed they caused the corporation to issue corrective disclosures before the transaction was ultimately abandoned.  After first determining that the plaintiffs were entitled to credit for only one of the purported 11 additional disclosures, the court began its discussion of the fee to which the plaintiffs were entitled by noting that "all supplemental disclosures are not equal."  When quantifying the fee award for additional disclosures, the court "evaluates the qualitative importance of the disclosures obtained."  While one or two meaningful additional disclosures might merit an award of $500,000, prior precedent in contested fee cases reveals that less meaningful disclosures yield much lower awards.  With that in mind, the court awarded $80,000, in large part because the disclosures were not particularly meaningful and the plaintiffs had not actively litigated the case after filing, instead seeking to negotiate a settlement.

The court used three recent opinions to support its conclusion that an award of only $80,000 was sufficient under the circumstance. In the 2006 case In re Triarc Companies Shareholders Litigation, the court awarded $75,000 in fees and expenses for the additional disclosure that the chairman of the special committee thought the deal price was inadequate where the plaintiffs had done nothing after the disclosure mooted the claims in the amended complaint to create any benefit.

In the 2009 Chancery Court case In re BEA Systems Inc. Shareholders Litigation, the court awarded fees and expenses of $81,297 where supplemental disclosures were made before discovery, preliminary injunction briefing and hearing, but the injunction was denied.

Finally, in 2010's Brinckerhoff v. Texas Eastern Products Pipeline Co., the Chancery Court awarded fees and expenses of $80,000 to an objector to a settlement who settled his objection in exchange for additional disclosure from the corporation as Form 8-K.

The consistent thread throughout these opinions, including the recent Sauer-Danfoss decision, is that non-meaningful disclosures that were agreed to after little work by plaintiffs will not merit substantial fee awards.

What effect, then, does the court’s reluctance to award large fees for additional disclosures combined with the court’s criticism of "disclosure only" settlements have on class action and derivative litigation going forward?

First, it may provide a disincentive for plaintiffs firms to continue to file litigation in Delaware challenging transactions.  The data showing a decrease in the number of lawsuits filed in the Court of Chancery has been readily available for some time now.  While smaller fee awards and higher criticism of "disclosure only" settlements cannot be the sole basis for the decrease in filings in the Court of Chancery, it likely plays some role.

Second, the use of the "disclosure only" settlement may become a thing of the past due to the risk for both sides.  Plaintiffs may not be willing to enter into a "disclosure only" settlement because they know they are at risk they will not be awarded a substantial fee.  Defendants may not be willing to enter into a "disclosure only" settlement because they do not want to put at risk their global release if the settlement is rejected as unfair.

To be clear, there is nothing in the Court of Chancery’s current jurisprudence to suggest that a "disclosure only" settlement is per se impermissible.  What is clear, however, is that to the extent that the parties to stockholder litigation challenging a business combination believed they could settle a case for the relatively inexpensive cost of making additional information available to the stockholders, that path must be followed carefully while keeping in mind the authorities cited above.

Peter B. Ladig (pladig@morrisjames.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group.  He represents both stockholders and directors in corporate litigation.  The majority of his practice is in the Delaware Court of Chancery, although he has extensive experience in the other state and federal courts in Delaware and has been involved in over 50 published decisions.  The views expressed herein are his alone and not those of his firm or any of the firm's clients.
 

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'Material Adverse Change' Clauses Protect Against Loss of Customers and Suppliers

Lewis H. Lazarus and Jason C. Jowers
This article was originally published in the Westlaw Journal Delaware-Corporate | May 4, 2011

In the article, Lewis H. Lazarus and Jason C. Jowers discuss the need for transactional and litigation attorneys who negotiate or litigate material adverse change clauses to focus on the particular language at issue as differences in phrasing could affect whether a seller is protected from a buyer's claim of breach.

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Ignoring Chancery Court's Guidance on How to Act in Merger Transactions Could Jeopardize Deals

Lewis H. Lazarus
This article was originally published in the Delaware Business Court Insider | May 04, 2011

The Delaware Court of Chancery, mindful of its role as a pre-eminent business court, works hard to communicate its expectations of officers and directors and their advisers.  That facilitates predictability.  Companies can be bought or sold with reduced risk that proposed transactions will be enjoined.  The corollary is that when advisers and their boards do not follow the rules, they put their clients’ transactions at risk.  Two recent cases illustrate that the Delaware Court of Chancery will not hesitate to enjoin a transaction where parties ignore clear guidance from prior opinions.

In its Feb. 14 decision in In re Del Monte Foods Co. Shareholders Litigation, the Court of Chancery enjoined a merger transaction from closing for 20 days and voided the deal protection terms that would have made a competing bid more expensive during that time period.  It did so because of conflicts of interest by the seller’s investment adviser.  The conflict arose because the seller’s investment adviser worked with the buyer to develop its merger proposal without telling the board, in apparent violation of a confidentiality agreement arising out of a previous failed effort to sell the company.  It then sought a role in providing buy-side financing.  All this while acting as financial adviser to the seller.

In enjoining the transaction the court relied on In re Toys "R" Us Inc. Shareholder Litigation, a 2005 case in which the court held that generally "it is advisable that investment banks representing sellers not create the appearance that they desire buy-side work, especially when it might be that they are more likely to be selected by some buyers for that lucrative role than by others."

Here the court found the investment adviser failed to disclose its conversations with prospective buyers or that it sought from the beginning to provide financing to the buyers.  This prevented the board from taking steps to protect the integrity of the process.  It also caused the seller to incur greater fees because once it was disclosed that the investment adviser sought to provide buy-side financing, the conflict required the board to obtain a new investment banker to opine on the fairness of the transaction.  Thus, while "the blame for what took place appears at this preliminary stage to lie with Barclays, the buck stops with the Board," the court said in Del Monte.

The remedy the court fashioned was unique — voiding the deal protection terms while enjoining the closing to permit a 20-day go-shop — but reflects the traditional equity power of the court to fashion a remedy tailored to the breach.  The court had no problem voiding the contractually bargained-for deal protection terms where the buyer knowingly participated in the board’s breach of fiduciary duty.  In so doing, the Del Monte court emphasized, "After Vice Chancellor [Leo] Strine’s comments about buy-side participation in Toys 'R' Us, investment banks were on notice."

Three weeks later, in its March 4 decision in In re Atheros Communications Inc. Shareholders Litigation, the Court of Chancery enjoined another transaction where the board failed to disclose the nature and amount of the investment adviser’s fee.  In Atheros the court found that stockholders voting on a proposed merger transaction would find it important to know that the investment adviser who rendered the fairness opinion upon which the board relied would receive 98 percent of its fixed fee only if a transaction closed.  The court was not troubled by the contingent fee per se, but rather by the fact that more than 50 times the portion that was otherwise due would be received only if a transaction closed.  As the court held, "the differential between compensation scenarios may fairly raise questions about the financial adviser’s objectivity and self-interest."

An additional factor justifying the court’s entry of injunctive relief was that the board did not disclose how soon in the process the seller’s CEO, who actively participated in negotiating the transaction price, knew that he would be staying on and receiving compensation from the buyer.  The court thus required additional disclosure on this point, finding that information that the CEO knew he would receive an offer of employment from the buyer at the same time he was negotiating the offer price would be important to a reasonable stockholder in deciding how to vote.

Both of these cases demonstrate the vitality of the court’s observation in Del Monte, cited in Atheros, that "because of the central role played by investment banks in the evaluation, exploration, selection, and implementation of strategic alternatives, this court has required full disclosure of investment banker compensation and potential conflicts."

That guidance means that practitioners and advisers would be well-served to avoid conflicts, to counsel their clients to avoid them, and to disclose such conflicts promptly.  Boards must also ensure that possible conflicts on the part of management who participate in the sale negotiations are properly managed by the board and fully disclosed.  As these cases demonstrate, it is the board’s responsibility to manage the sale process and failure to follow clear guidance from the case law imperils prompt closing of potential transactions.

Lewis H. Lazarus (llazarus@morrisjames.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group.  His practice is primarily in the Delaware Court of Chancery in disputes, often expedited, involving managers and stakeholders of Delaware business organizations.  The views expressed herein are his alone and not those of his firm or any of the firm's clients.
 

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Court Of Chancery Sets Fee Guidelines

In Re Sauer-Danfoss Inc. Shareholders Litigation, C.A. 5162-VCL (April 29, 2011, revised May 3, 2011)

This will probably be the definitive decision on how to set the attorneys' fees in representative litigation where the benefit to the company and its stockholders is additional disclosures.  Not only does the decision explain how the Court will approach that issue, but it also contains a detailed table of fee awards in prior cases to serve as a guideline.

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Court Of Chancery Explains Step-Transaction Doctrine

Liberty Media Corporation v. The Bank of New York Mellon Trust Company, N.A. , C.A. 5702-VCL (April 29, 2011) affirmed, Del Supr September 21, 2011. Both Section 271 of the DGCL and many indentures provide that a corporation may not sell all or substantially all of its assets without stockholder approval.  For years, a recurring problem has been how to apply that law to a series of asset sales that when taken all together amount to a sale of almost all the company's assets.  This decision explains the so-called "step-transaction doctrine" under which such multiple sales may be aggregated to be considered one sale requiring stockholder approval. The short [and probably too simplistic answer] is that when the sales each have their own business justification, the Court will not aggregate them. Share

The Song of Preferred Stockholders: 'You Get What You Asked for, Not What You Need'

Edward M. McNally
This article was originally published in the Delaware Business Court Insider | April 27, 2011.

For a number of years, private equity investors bought preferred stock as their investment vehicle. That this stock was considered equity rather than debt made it particularly desirable for startup companies that need to conserve their borrowing capacity. For the investors, preferred stock also might have a favorable tax treatment on the inevitable day when it was redeemed by the issuing company. All the investor had to do was provide sufficient protection for itself by the rights given to its preferred stock by the issuer’s certificate of incorporation. Seems simple enough.

Yet even the most sophisticated equity investors have failed to get what they actually need to protect their investment. They have asked for literally dozens of different rights as preferred stockholders, only to find out later that they failed to get what they really needed to secure the return of their investment. While it is true that in some cases preferred stockholders are also owed the fiduciary duties owed to common stockholders, that is not good enough. After all, they are "preferred." Why have they failed to protect themselves?

There are two basic legal principles that affect the ability of preferred stockholders to protect their investment. First, it is settled Delaware law that preferred stockholder rights are based on their "contract," what the company’s certificate of incorporation provides for the preferred stock. The courts will not grant them rights they did not get in the certificate.

Two recent Delaware decisions illustrate this principle. On March 29. in Fletcher International Ltd. v. ION Geophysical Corporation, the Chancery Court said the preferred stockholder sought to protect its investment by bargaining for the right to consent to the sale of any stock by a company’s subsidiary. In that way the parent company’s most valuable assets, its subsidiaries, could not be diluted without the preferred stockholder’s approval. But when the parent company wanted to do a deal that the preferred stockholder did not approve, the parent company just formed a new subsidiary and sold that subsidiary’s stock itself. Because the certificate of incorporation only prohibited a stock sale by a subsidiary and not by the parent company, the court permitted the sale to go forward over the preferred stockholder’s objection. No amount of complaining about form over substance did the preferred stockholder any good. It still lost.

SV Investment Partners v. Thoughtworks Inc., a Nov. 10, 2010, Chancery Court decision, reached a similar disappointing result for the preferred investor. There, the preferred stock had the right to be redeemed out of "funds legally available" on the redemption date. On that date the company had a "surplus" — its assets were worth more than its debts. However, the court ruled that the preferred was not entitled to be redeemed. It reasoned that because the company had legitimate needs for its cash, those funds were not "legally available" for redemption. In short, the precise wording the preferred stockholders asked for in the certificate of incorporation did not get them what they needed to be redeemed.

Getting around this first legal principle of strictly limiting the preferred’s right is not as easy as just giving it the power to elect directors upon default. For then the second legal principle that affects preferred stockholder rights comes into play. Directors have a fiduciary duty to all stockholders, even if those directors have been appointed just by the preferred stockholders. Hence, in the Thoughtworks situation, even if the majority of the directors had been elected by the preferred stockholders, they well may have had a duty to not use its funds for redemption when other uses of cash were better for Thoughtworks.

Indeed, recent Delaware decisions have criticized directors elected by preferred stockholders who wrongly favor the preferred stock. Because of those decisions, I suspect that it is the desire to avoid assuming any fiduciary duty to other stockholders that causes some private equity investors to not seek board control even if they are not timely redeemed.

What then are the remedies of the poor preferred stockholder left to only the terms of his or her preferred stock "contract" in the face of ingenuous schemes to work around his or her rights?

To begin with, the reality is that most of the time preferred stock ends up with the preferences it asked for at the bargaining table. Even if redemption may be postponed beyond the redemption date, steeply accruing post-redemption date carrying charges cannot be ignored forever. The price to be paid is just too steep, particularly if the company is to be sold to a third party or go public. Moreover, private equity investors learn quickly. The loopholes validated by past decisions will close in the next deal. The information exchange is just too fast to permit a clever avoidance tactic to be used for very long.

Finally, as the Thoughtworks decision points out, there are multiple existing ways a preferred stockholder may protect his or her investment. Requiring that redemption be paid by a short-term note, drag-along rights or even a forced sale of the company may all protect preferred stockholders. The vigilant preferred investor will remain as "preferred" as he wants, so long as he knows what to ask for in advance. Careful drafting is the key to the desired result.

Edward M. McNally (emcnally@morrisjames.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. He practices primarily in the Delaware Superior Court and Court of Chancery handling disputes involving contracts, business torts and managers and stakeholders of Delaware business organizations. The views expressed herein are his alone and not those of his firm or any of the firm’s clients.
 

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Multi-Jurisdictional Litigation a Rich Vein of Issues for Chancery Court

Peter B. Ladig
This article was originally published in the Delaware Business Court Insider | April 20, 2011.

Settlements of multi-jurisdictional stockholder litigation challenging corporate transactions raise logistical and other issues for reviewing courts including the proper allocation of fees between and among competing plaintiffs.   Chancellor William B. Chandler III in In re Allion Healthcare Inc.  Shareholders Litigation recently addressed this problem and his opinion provides important guidance to practitioners.  Here, the problem was not the specter of a collusive settlement, as it was in the litigation arising out of the merger of Nighthawk Radiology Holdings Inc. (Nighthawk), previously reviewed in this space.

This time, the settlement was approved, but the counsel for plaintiffs in two different jurisdictions could not agree how to allocate the award of attorney fees between them, and required the intervention of the chancellor to resolve the dispute.  Not only is the chancellor’s analysis illuminating, he also used the opinion as an opportunity to suggest his preferred mechanism to address certain of the problems caused by multi-jurisdictional litigation.

On Oct. 18, 2009, Allion Healthcare Inc. (Allion) announced it had entered into an agreement contemplating a going-private merger transaction whereby Allion would merge with affiliates of private investment firm H.I.G. Capital LLC (HIG) and a group of Allion stockholders who together owned about 41 percent of Allion’s common stock. As a result of the merger, Allion’s unaffiliated stockholders would be cashed out for $6.60 per share.   In response to this announcement, lawsuits were filed in Delaware and other jurisdictions, including New York, alleging that the price to be paid in the merger was unfair and asserting claims of breach of fiduciary duty against Allion, its directors and HIG in connection with the merger.  The first lawsuit was filed in New York on Oct. 20, 2009. A week later, a lawsuit was filed in Delaware, followed by another lawsuit in Delaware filed by Steamfitters Local Union 449.

Defendants moved to stay the New York action in favor of the Delaware proceeding.  That motion was ultimately denied, but not before counsel for the plaintiffs in the Delaware action notified the Court of Chancery that the Delaware plaintiffs, New York plaintiffs and the defendants had reached an agreement for the defendants to supplement their proxy statement in exchange for the withdrawal of the motion for a preliminary injunction.

After the merger closed, the plaintiffs in New York and Delaware filed amended complaints.  Defendants filed motions to dismiss in both jurisdictions.  The motion to dismiss in New York was largely denied on Aug. 13, 2010, by which time the motion to dismiss in Delaware was fully briefed but not decided.

The parties to the Delaware proceeding began discussing settlement in August 2010, and informed the Court of Chancery in September that they had reached an agreement in principle to resolve the Delaware action.  The New York plaintiffs learned of the settlement of the Delaware action on the same day.  On Nov. 12, 2010, the parties to the Delaware action filed a stipulation of settlement providing for an additional $4 million to be paid to the unaffiliated stockholders of Allion.  The New York plaintiffs filed an emergency motion to intervene in the Delaware proceeding to either: (1) stay the action, (2) reject the proposed settlement, or (3) allow the New York plaintiffs to take discovery on the merits of the action and the proposed settlement.  The court denied that motion, finding that the New York plaintiffs were well aware of the settlement, and permitted the New York plaintiffs to object to the settlement at the hearing to approve the settlement.

At the hearing, the court approved the settlement and awarded attorney fees and expenses of $1 million: $250,000 for the improved disclosures and $750,000 for the improved merger consideration.  The court allowed counsel for the plaintiffs the opportunity to create a fee-splitting solution.  They were unable to do so, and the court was required to resolve the issue.

Suggesting an Approach

Before addressing the merits of the issue before it, the court noted that the issue of fee-splitting is another practical problem caused by multi-jurisdictional litigation.  While discussing generally the other issues created by multi-forum litigation, in footnote 12 to the March 29 opinion in In re Allion Healthcare Inc. Shareholders Litigation, the chancellor suggested his solution:

"My personal preference, for what it’s worth," the chancellor wrote, "is for defense counsel to file motions in both (or however many) jurisdictions where plaintiffs have filed suit, explicitly asking the judges in each jurisdiction to confer with one another and agree upon where the case should go forward. In other words … my preference would be for defendants to ‘go into all the courts in which the matters are pending and file a common motion that would be in front of all of the judges that are implicated, asking those judges to please confer and agree upon, in the interest of comity and judicial efficiency, if nothing else, what jurisdiction is going to proceed and go forward and which jurisdictions are going to stand down and allow on jurisdiction to handle the matter….’ Judges in different jurisdictions might not always find common ground on how to move the litigation forward. Nevertheless, this would be, I think, one (if not the most) efficient and pragmatic method to deal with this increasing problem.  It is a method that has worked for me in every instance when it was tried."

This pragmatic solution is typical of the Court of Chancery’s approach to many issues, both procedural and substantive.  Indeed, the notion that the judges hearing related matters should collectively determine where the matter should go forward is similar in concept to the suggestion by the special counsel in Nighthawk that all courts hearing a related matter should be made aware of events in the other proceedings.  While some momentum appears to be building toward this type of disclosure, counsel representing defendants in a similar position would be wise to heed the suggestions in Allion and Nighthawk even before more definitive guidance emerges.

Counsel Fees

Turning to the merits of the fee dispute, the court found the analysis straightforward.  The court found that the disclosure portion of the fee was appropriately split equally between the New York and Delaware plaintiffs.  Although the New York plaintiffs may have argued later that the disclosures were inadequate to support a settlement, they still contributed to the benefit achieved by the disclosures by independently negotiating for them.

Unlike the disclosure portion of the fee, the court found that the efforts of the New York plaintiffs did not contribute to the benefit achieved by the increased merger consideration, and awarded all of the $750,000 increased consideration fee to the Delaware plaintiffs.

In Delaware, the filing of a meritorious action followed by a benefit conferred to a class creates a rebuttable presumption that the benefit was caused by the litigation.   When similar lawsuits are litigated in multiple fora, the presumption of a causal relationship between the litigation and the benefit achieved applies only to the Delaware litigation.   Affording the presumption to all actions would encourage placeholder filings in other jurisdictions, wasting judicial resources and making it more difficult to reach a settlement.

Here, the New York plaintiffs did not sign on to the settlement or otherwise support it.   Thus, the only way the New York plaintiffs could merit a fee is if the New York litigation somehow caused the Delaware settlement.  Here, counsel for the New York plaintiffs argued that even though it played no direct role in negotiation of the increase of the merger consideration, it created an "atmosphere" where the Delaware plaintiffs were able to negotiate a resolution.  The court rejected that argument for many of the same reasons it has been rejected before — the impact on the Delaware litigation was purely conjecture and in the absence of sufficient evidence to the contrary, a settlement achieved by counsel for Delaware plaintiffs should be attributed to them.  The court also rejected the New York plaintiff’s argument that the denial of the motion to dismiss in the New York action "moved" the case along to encourage settlement, finding that the evidence presented at the settlement hearing refuted this argument.

The chancellor’s decision in Allion, along with the report of the special counsel in Nighthawk, provide invaluable guidance to attorneys counseling directors and corporations involved in multi-jurisdictional litigation with a Delaware component.  Those who counsel these groups would be wise to review these issues carefully when advising them.

Peter B. Ladig (pladig@morrisjames.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group.   He represents both stockholders and directors in corporate litigation.  The majority of his practice is in the Delaware Court of Chancery, although he has extensive experience in the other state and federal courts in Delaware and has been involved in over 50 published decisions.  The views expressed herein are his alone and not those of his firm or any of the firm's clients.
 

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Court Of Chancery Enforces Scheduling Order

Encite LLC v Soni, C.A. 2476-CC (April 15, 2011)

When the Court of Chancery establishes discovery deadlines, it is not kidding.  The Court is consistently generous with lawyers who need more time and ask for it for a good reason and ahead of deadlines.  But when the lawyer fails to ask until the deadline has passed, the Court is not so kind and, as here, may deny the request.

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Are Directors Vulnerable for Lack of Oversight When a Natural Disaster Strikes?

Edward M. McNally
This article was originally published in the Delaware Business Court Insider | April 06, 2011
 
The recent events in Japan prompt the question of whether the members of a corporation’s board of directors have any exposure to liability when a natural disaster strikes their company. The potential claim would be that as part of their duty to oversee the company’s risk management, they should have better protected their company from the losses resulting from a natural disaster.

Of course, most people view such national disasters as "black swans," or events no one anticipates will happen.

Surely directors are not responsible for future events no one anticipates.

Or are they?

The analysis of this issue begins with a review of the directors’ duty to oversee their corporation’s activities to proactively prevent losses. In Delaware, this duty is often referred to as a "Caremark" duty, after the decision that proposed such a duty exists. Delaware courts have repeatedly described a Caremark claim as possibly the most difficult claim to win under Delaware corporate law. Yet, Caremark claims continue to be filed, albeit less frequently than other types of claims against directors.

A Caremark claim is particularly dangerous to directors. The Delaware Supreme Court has characterized some Caremark claims as breaches of the duty of loyalty that all directors and officers owe to their corporations. While that may not seem too different from a claim based on lack of care, the difference is significant.

The Delaware statute permitting a corporation to immunize directors from damages does not apply to breach of loyalty claims. Thus, director liability under a Caremark claim may have serious consequences if D&O coverage is not sufficient.

Regardless of whether the plaintiff characterizes the claims as a breach of the duty of loyalty or care, the claims will have one common characteristic. Typically, Caremark plaintiffs allege that the directors failed to take affirmative steps in some way that would have prevented damage to the corporation. That failure cannot be just simple negligence because under Delaware law, simple negligence is insufficient to constitute a breach of a director’s duty. Rather, at least gross negligence must be alleged to state a claim.

Thus, to state a Caremark claim the complaint usually alleges that the directors were aware of their duty to take action and that their failure to do so was grossly negligent. That awareness usually depends on "red flags" -- warnings the directors received before they failed to act. If the directors receive enough red flags and ignore them, then it may be said they were grossly negligent, and a Caremark claim exists.

However, the courts have also permitted a Caremark claim even without any red flags. When directors have utterly failed to do any monitoring of corporate affairs or put in place some system of supervision over corporate activities, a Caremark claim may be brought when damages occur because of bad conduct by employees. Directors just cannot simply sit back and do nothing, even in the absence of a warning that things are amiss.

Does it not follow that almost by definition a natural disaster is not anticipated because it is out of the ordinary and no red flags went up? That does not necessarily follow when you think about it. For example, it is reported that Japan had at least one prior earthquake that seriously affected a nuclear power plant. Japan has building codes that require earthquake protection. Does it follow that the past damage to a nuclear plant and the building codes generally together constituted red flags that directors of Japanese companies in the nuclear power business could not safely ignore? What do directors need to do to avoid liability for natural disasters?

In the final analysis, the answer to this question will depend upon what was reasonable under the circumstances. A large corporation may receive literally thousands of complaints each year from customers, employees or regulators. It is not reasonable to ask a board of directors to consider each of those complaints as red flags requiring their inquiry. The board would do nothing else if it had to look into a thousand complaints. Instead, what the board should do is have in place some process that is designed to catch wrongdoing, filter complaints and send to the board only those few that warrant further action by the board of directors.

That same analysis applies to the board’s duties concerning potential natural disasters. It is to be expected that some level of natural events may occur and lead to damages to a corporation’s infrastructure. Storms are even classified by how often they are expected to occur, with a "10 years storm" expected at least once a decade. The board should have in place insurance and other measures that it has been advised by experts are sufficient to protect their corporation from natural disasters that are reasonably likely to occur.

The board should periodically review the company’s insurance and disaster avoidance plans, at least to be satisfied that appropriate steps have been taken by management to address that threat to the company.

Not every potential disaster needs to be planned for, just those that are actual threats. If these basic steps are taken, directors should not be held liable if a natural disaster causes an anticipated harm to their company. We have not yet reached the point where the courts will expect directors to foresee black swans. Some risk is necessary for success. A properly functioning board is entitled -- and indeed expected -- by its investors to take such risks.

Edward M. McNally (emcnally@morrisjames.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. He practices primarily in the Delaware Superior Court and Court of Chancery handling disputes involving contracts, business torts and managers and stakeholders of Delaware business organizations. The views expressed herein are his alone and not those of his firm or any of the firm’s clients.

 

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Delaware Superior Court CCLD Interprets Complex Contract

Textron Inc. v. Acument Global Technology Inc., C.A. 10C-07-103-JRJ CCLD (April 6, 2011)

The new Complex Civil Litigation Division of the Delaware Superior Court has attracted over 40 new cases because of its special  treatment of business disputes.  This opinion illustrates that Court will provide the careful treatment of contract disputes that is needed by the parties. Applying settled Delaware law to the issues presented, the Court denied a motion for judgment on the pleadings while providing the litigants guidance that may lead them to resolve their dispute. 

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Delaware Superior Court Recognizes New Tort Theory

Allen Family Foods Inc. v. Capital Carbonic Corporation , C.A. N10C-10-313 JRS CCLD (March 31, 2011)

In this decision the Delaware Superior Court declined to follow federal precedent and adopted the liability theory of the Restatement (Second) of Torts Section 766A. Under that Section, a claim is permitted for interfering with a plaintiff's contract rights with a third party even when the contract is not broken.  This is different from a more typical interference claim where the third party refuses to perform because of some wrongful act.

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Court Of Chancery Explains How To Divide Fees

In Re Allion Heathcare Inc. Shareholders Litigation, C.A. 5022-CC (March 29, 2011)

How to divide the fees awarded in a multi-jurisdiction case is a recurring problem.  As the Chancellor explains in this opinion, it is preferable if the various courts are notified of a settlement and asked to decide which court should resolve any problems.  That has worked well.

However, when the lawyers are too stubborn to do so, then the Court will apply the principle established long ago in the fabled story, The Little Red Hen.  She who bakes the bread is she who eats the bread.

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Court Of Chancery Again Explains Preferred Stock Rights

Fletcher International LTD v. Ion Geophysical Corp., C.A. 5109-VCS (March 29, 2011)

This is another in the line of decisions that stress that preferred stockholder rights are what is set out in the certificate of incorporation and nothing more.  Thus, if the preferred stockholders bargain for the right to consent to the sale of stock by any subsidiary, then they do not also have the right to vote on the sale of subsidiary stock by the parent.

To be fair, this brief description does not do justice to the Court's careful reasoning and simplifies the charter provisions at issue.  However, best to state the principle starkly to avoid any misunderstanding.

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Court Of Chancery Summarizes Past Fee Awards

In Re Emerson Radio Shareholder Derivative Litigation, C.A. 3392-VCL (March 28, 2011)

Delaware lawyers are often asked to estimate what the Court of Chancery will award in fees following settlement or trial of a derivative action. Well this decision summarizes those fee awards:

10 - 15% for a fast settlement

15 - 25% for contesting motions and other pretrial work that leads to a settlement

25 - 33% for winning after trial

All these percentages apply to monetary settlements, but the Court also explains how to determine fees in cases invovling non-monetary settlements.

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